varying risks, then those with the greatest risks are more likely to buy

insurance. This adverse selection works to the detriment of insurers.

Unchecked, it would make underwriting unprofitable.

Insurers protect themselves from adverse selection by attempting to

measure risk and either charging more from the higher risks, or by

refusing to cover them at all. For example, motor insurers charge higher

premiums for cars and drivers that are statistically more likely to be

involved in accidents. Medical insurers usually exclude pre-existing

conditions (i.e. any illness that pre-dates the start of cover) from

their cover in order to deter people from buying cover after a problem

has been diagnosed.

In part, the problem of adverse selection is dealt with by the insurers'

attempts to measure risk, which is anyway necessary to setting

premiums. However, this still leaves insurers with a significantly

problem in any circumstances where the insured may have more information

than they do. This is why, unlike other contracts, insurance contacts

are agreed uberrimae fides

(in utmost good faith). This means that a persons (which includes

organisations as well as people) taking out insurance are required to

inform the insurer of all relevant information, not just what they are

directly asked for.

In some countries there are restrictions on what information insurers

can gather, which can affect their ability to limit adverse selection.

In the UK, life insurers cannot require applicants for cover below a

threshold level to take genetic tests, even though it is fairly easy for

people to have tests performed and conceal the results.

Adverse selection has similarities to moral hazard. Both change risks to insurers as a result of customer behaviour.

Annual premium equivalent

It is common (in the UK) to use annual premium equivalent (APE) to allow

comparisons of the amount of new business (policies written during the

period) gained in a period by insurance companies with different

proportions of single premium and regular premium business.

It is clearly not possible to compare the total amounts of premiums as

single premium policies bring in more money up front than equivalent

regular premium policies.

Annual premium equivalent is the total amount of regular premiums from

new business + 10% of the total amount of single premiums on business

written during the year.

PVNBP is a more sophisticated alternative that is part of the European Embedded Value standards.

Annuity

An annuity, in financial theory, is a series of equal fixed payments

made at regular intervals that terminates at some point. A similar

stream of payments that does not terminate is called a perpetuity.

An annuity is also a financial produce, usually purchased from a life

insurance company, that pays a regular income until the death of the

purchaser in return for a lump sum. The insurance company needs to use

the lump sum and the income they get from investing it to meet the

annuity payments. As the length of any person's life is uncertain the

insurance company bears a risk.

A life assurance

policy can be thought of as the opposite of an annuity. With a life

assurance policy, the insurance company makes a loss when each insured

person dies within the term of the policy as it has to make a payment.

With an annuity, the insurance company makes a gain when each insured

person dies.The opposing natures of annuities and life insurance means that the annuities an insurance company sells hedge

certain risks to its life policy payouts and vice-versa. For example,

if the death rate rises then the insurance company will have to pay out

more on life policies but less on annuities.

Assurance

Assurance is insurance against events that will inevitably occur.

The common example of assurance is life assurance.

There is no real difference between assurance and insurance, although

the long term over which life assurance is taken complicates all the actuarial calculations linked to it.

Bancassurance

Bancassurance is the selling of insurance and banking products through

the same channel, most commonly through bank branches selling insurance.

The sales synergies available have been sufficient to be used to justify mergers and acquisitions.

Some of the sales synergies come through the extensive customer base

that banks have. Some come from opportunities to sell insurance together

with some banking products. For example, banks generally insist on life

insurance for mortgage borrowers. Although borrowers are not obliged to

buy insurance from the lender, many do (despite it often being very

over-priced) as it is an easy option.

Credit cards and personal loans create opportunities for banks to sell protection insurance (another high margin business) and the knowledge a bank has of its customers' finances creates opportunities to sell other products.

Bancassurance has become significant. Banks are now a major distribution

channel for insurers, and insurance sales a significant source of

profits for banks. The latter partly being because banks can often sell

insurance at better prices (i.e., higher premiums) than many other

channels, and they have low costs as they use the infrastructure

(branches and systems) that they use for banking.

What has not happened to any great extent, at least in Britain, is the

merger of banks and insurers to form integrated bancassurance companies.

Catastrophe bonds

Catastrophe bonds (cat bonds) are a form of insurance securitisation.

They are an alternative to insurance that transfers risk to investors

rather than insurers. They are legally not insurance, which has some

important consequences.

The most important of these differences are that they are not uberrimae fides and that they can be bought by any investor (not just a insurer). See credit default swaps for a more detailed discussion of the differences between insurance and non-insurance contracts.

Catastrophe bonds may be issued by an insurer to spread risk, in order

to protect their own balance sheets in the event of large scale payouts

such as those caused by natural disasters. They therefore also reassure

policy holders.

They may also be issued an entity that requires insurance against a

single large risk. In this case they can be regarded as a form of

insurance disintermediation. A good example of was FIFA's issue of $260m worth of catastrophe bonds against cancellation of the 2002 football world cup.

Catastrophe bonds are usually issued by an SPV.

The SPV will keep bondholders' money and pay them interest. It will

also usually receive a premium from the insured. In the event of the

"catastrophe" occurring the bondholders lose their money and it is used

to pay the insured.

In return for a low risk of losing all their money cat bond holders get a

better yield and an otherwise reasonably safe investment. The risk is

also usually an easily diversifiable one.

Claims equalisation reserve

The claims equalisation reserve is a balance sheet

item showing funds an insurance company has (nominally) set aside in

order to smooth fluctuations in the cost of claims. The claims

equalisation reserve is not required and is used at a company's

discretion.

It produces more consistent revenues, but it is obviously something that lends itself to abuse.

There is a certain irony in there being a recognised balance sheet item

that allows insurance companies to use a (limited) form of profit

smoothing — something that accounting standards are designed to make as

difficult as possible in any other industry. There is, of course, a

reason for this: the availability of actuarial estimates of the "normal" level of claims provides a sounder basis for smoothing.

Claims ratio

The claims ratios is claims payable as a percentage of premium income. This is the equivalent of gross profit margin

for an insurance business. An insurer's investment income is also part

of its core business so the comparison with gross profit is not exact.

The loss ratio is similar, but is sometimes defined subtly different as claims paid (rather than payable).

The claims ratio can be combined with the expense ratio to produce the combined ratio.

Combined ratio

In general (non-life) insurance, the combined ratio is claims and operating expenses as a percentage of premium income.

If it is less than 100% the company is making an operating profit

on investment underwriting. A company may still make a profit despite a

combined ratio of over a 100% as insurance companies normally have

substantial investment income.

It is may include or exclude amounts reimbursed by reinsurers. It is important to be clear which of these variants is being used in any instance.

The combined ratio combines two types of costs: claims and operational expenses. It can be decomposed into two ratios, the claims ratio and the expense ratio to give a more detailed breakdown.

Embedded Value

The embedded value of a life insurance business is an estimate of the

value of both its net assets and the income stream expected from

policies already in force.

E = PV + NAV

where E is the embedded value,

PV is the present value of future cash flows on policies already in force and

NAV is the company's NAV with investments valued at market value.

The future profits do not include the value of policies that

the company will sell in the future, only those already sold. Policies

that the company can expect to sell in the future are an important

component of the difference between the embedded value and the actual

value of the business to investors.

European embedded value

European Embedded Value (EEV) is a standardised calculation of embedded value and related numbers that is being adopted by European insurance companies to make their results more meaningfully comparable.

In general, the higher the ratio, the more surplus capital a company has available.

Moral hazard

A person or organisation who has insurance cover may be be more prepared to take risks than someone who does not.

For example, someone whose car is insured against theft may be more

careless about reducing the chances of theft than they would have been

without such insurance.

This is partly why insurance companies require excesses (the amount of a

claim paid by the person covered) on most claims, and reduce premiums

quite sharply as excesses rise. It is also why insurers are very careful

about the valuation of what they insure and why they are not legally

required to pay more than the real value of what they cover, even if it

has been insured for more.

Moral hazard can also occur outside insurance, although it is less of a

concern. Banks and financial institutions often have implicit state

guarantees (not formal or legally binding guarantees, but a general

expectation that they are too big/important to fail). This creates an

incentive for the management and shareholders to take bigger risks as

they will benefit from gambles that work, but the state will pay for

those that do not. This is similar to the agency conflict between shareholders and debt holders.

New business margin

New business margin in a profit measure used by insurers. The

measurement of new business (the equivalent of sales when calculating profit margins in other industries) is less straightforward than similar numbers in other industries. It is common practice to use the present value of net new business (PVNBP), and in the EU this would be the EEV measure.

Given this:

new business margin = profit on new business ÷ PVNBP

The profit number used also needs to be calculated on a basis

consistent with the PVNBP denominator. For example, if PVNBP is an EEV

number, then the profit number should be the EEV profit on those sales.

As with most of the important insurance numbers, new business margin is sensitive to actuarial assumptions.

Outstanding claims reserve

The outstanding claims reserve is the provision made in the balance sheet

of an insurance company for all claims that have been made and for

which the insurer is liable, but which had not been settled at the

balance sheet date.

Premium earned

Premium earned is the amount of premiums earned by the risk covered by an insurer during a period. Premium written

is the amount customers are required to pay for policies written during

the year. The two differ because of the timing of premium payments.

For example if:

An insurance policy that runs from the 1st July 2005 to the 30th June 2006.

The premium is £1,000.

The insurance company has a December year end.

Then, as the policy runs for six months of this year and six months of

next, half the risk is taken in the current year and half next year.

Therefore the premium earned is £500 for 2005 and £500 for 2006.

However as the cover is agreed during 2005, the gross premium written is £1,000 for 2005.

Premium income

The revenues an insurance company receives as premiums paid by customers

is its premium income. This excludes other revenue streams, most

importantly investment income.

The most important definitions of premium income are premium earned and premium written.

Premium written

The amount of premiums customers are required to pay for insurance

policies written during the year. This contrasts with premium earned

which is the amount of premiums that a company has earned by providing

insurance against various risks during the year.

It may be measured gross (before deduction of reinsurance costs) or net (after reinsurance costs). It is a measure of sales.

PVNBP

Present value of new business premiums (PVNBP) is a measure of sales that forms part of the European Embedded Value accounting principles that have been adopted in order to provide uniform measures for all European insurers.

PVNBP is, like annual premium equivalent (APE), a way in which the values of single and regular premium new business sold during a financial period can be combined to give a single sales number. It is:

value of single premiums + present value of regular premium streams

There are two major differences between PVNBP and APE:

PVNBP adjusts regular premiums to make them comparable with single premiums, APE does the opposite.

increase profits, but be aware that this may all ready be reflected in

the price. It is most useful for value investors looking for a safe source of profits — what Warren Buffet calls a moat.

Regulator capture may be reversed if failure become apparent, or

consumers become active enough: banking after the global financial

crisis is a good example of this.

Reinsurance

Reinsurance is simply insurance for insurers. It allows them to pass on

risks that they cannot, or do not wish, to absorb themselves.

Insurance companies typically insure some (but not all) of the risks

that they are exposed to with specialist reinsurers. The insurer can

then recover a part of the claims they pay out from the reinsurer. This

reduces the risk of the failure of the insurer in the event of a

catastrophic event, such as a natural disaster, that may produce a very

high level of claims.

Reinsurance companies are usually very large, well funded and have a wide spread of operations.

Risk measures such as solvency margin are adjusted for the level of reinsurance cover.

There are two types basic types of reinsurance arrangement, facultative reinsurance and treaty reinsurance.

Facultative Reinsurance

This is the arrangement of separate reinsurance for each risk that the

insurer underwrites. This is normally part of an on-going arrangement

and the insurer continually offers policies to the reinsurer, and the

reinsurer decides whether to accept each or not individually. Obviously

this requires a lot of work and is now generally regarded as too

expensive in human resources to be practical.

Treaty Reinsurance

Treaty reinsurance is arranged for a block an insurer's underwritten

policies. The reinsurer reinsurers a whole large chunk of the insurer's

business. This means that the reinsurer does not need to scrutinise each

policy individually and the insurer does not have the added workload of

providing the reinsurer details of each and every risk it underwrites.

Reinsurance may be agreed on a pro rata basis or a stop loss basis:

Pro rata basis: the reinsurer gets a fixed proportion of

the premium on the risks covered, and in return pays out a fixed

proportion of the claims made.

Stop loss basis: the insurer will absorb losses up to a limit (the

retention), and reinsurer will absorb almost all losses above that

limit.

Reinsurnace may also cover only individual risks of above a certain size or losses above a specified excess.

Major reinsurers include Swiss Re, Munich Re, General Re, and (collectively) Lloyds syndicates.

Lloyd's of London

Lloyd's is an insurance market. It provides a framework in which buyers of insurance can be matched with sellers. It is not an insurance company;

Lloyd's is particularly popular for risks that are hard to place elsewhere.

As with any market it has its brokers, and there are many insurance brokers that bring business to Lloyd's.

On the other side are investors who underwrite risks through Lloyd's syndicates that are run by managing agents.

Each syndicate is, in essence, an insurance company. The syndicates pay

claims, not Lloyd’s itself. This is why Lloyd's can be described as a

market: its function is to match the syndicates with their clients.

Reinsurance retention ratio

The reinsurance retention ratio is:

net premium written ÷gross premium written

It is a rough measure of how much of the risk is being carried by an insurer rather than being passed to reinsurers.

Single premium vs regular premium

Single premium insurance policies are those on which the customer pays a

single one-off payment. The insurer gets an up front payment for

covering a continuing risk over a period of time. This contrasts with

regular premiums which give the insurers an income stream in return for

covering the risk. General insurance is paid with regular premiums but

single premiums are not uncommon in life assurance.

Annual premium equivalent or PVNBP can be used to measure insurers' new business using a single number that combines regular and single premium business.

Solvency margin

The solvency margin is a minimum excess on an insurer's assets over its

liabilities set by regulators. It can be regarded as similar to capital adequacy requirements for banks. It is essentially a minimum level of the solvency ratio, but regulators usually use a slightly more complex calculation. The current EU requirement is the greatest of:

18% of premium written up to €50m plus 16% of premiums above €50m.

26% of claims up to €35m plus 23% of claims above €35m.

Some other adjustments are also made. Premiums for high risk classes of

These are those that may cause a "reasonable insurer" not to underwrite the risk, or to underwrite it on different terms. Failure to do this can invalidate insurance.

The reason insurance contracts are agreed uberrimae fides is that it helps to reduce adverse selection. If insurance contracts were agreed caveat emptor

(buyer beware) like most other contracts, then the slightest omission

from insurance proposal documents would attract significant numbers of

people who could exploit the loophole.

The contrast of uberrimae fides with caveat emptor

is legally correct, in that contract law in itself imposes no duties on

either party to act fairly. However there are often other protections in

place - particularly for consumers. Most transactions are covered by

laws (such as the Sale of Goods Act), regulators and implied terms of

contract.

Underwriter

An underwriter is someone who takes a financial risk (relieving another party of it) in return for a fee.

The most familiar underwriters are insurance companies, whose entire business is the underwriting of a wide range of risk.

Some new issues, most importantly IPOs,

of securities are underwritten, usually by investment banks. The

underwriter agrees to buy any securities that unwanted by the market. If

the offer is not as successful as expected the underwriter may make a

loss.

The underwriter does not usually take as large a risk as may appear. New

issues, especially large ones, are priced low enough to make it likely

that the issue will be fully subscribed. This is why stags usually make a gain on IPOs.

The underwriter of an issue of a security may be a single investment bank or, especially in the case of a large IPO, a syndicate of banks.

Underwriting is very lucrative, and there has been a long running

controversy over whether this is an indication that investment banks are

colluding on pricing.

Unearned premium reserve

The unearned premium reserve is an item that appears on insurers balance sheets. It shows the total amount of premiums written but not yet earned. The unexpired risk reserve is very similar to the unearned premium reserve.